Misadventures in Canadian Aviation

With the 2024 portfolio review, the year was punctuated by making some bad investment errors. It has been a long time since I have erred in this frequency, both on the errors of commission and errors of omission. I estimate my stupidity to date this year has cost me about a +10% differential had I just stayed away from the computer in three notable instances – in other words, terrible.

To generalize some permutations of transactions where things can go wrong:

1. You get your research correct, purchase, and then the stock goes nowhere (or worse yet, down!)
2. You get your research correct, purchase, and the stock skyrockets… except your position was 0.5% of your portfolio.
3. You get your research correct, purchase, and then the story changes, you sell, and then… oops! The “story changing” part wasn’t so right after all and the stock skyrockets.
4. You get your research correct, purchase, and the stock flops regardless.
5. You get your research correct (showing the prospect is a dud), decide NOT to purchase, and the stock skyrockets anyway.
6. You get your research incorrect, purchase, and the stock correspondingly flops.
7. You get your research incorrect (showing the prospect is a dud when in reality it is great!), do NOT purchase, and the stock skyrockets.

I’ve probably missed a few in this list as continuing on is feeling quite depressing. In addition, there is the flip side of the equation when you have a position in something, and the decision to sell has similar outcomes.

While writing this out feels like re-opening old wounds, I’ll outline one example in the hopes that the pain of writing this will hopefully prevent me from pounding my head on the drywall in the future.

The topic of the day is Canadian aviation companies.

As the whole world knows, starting March 2020, shutting down borders internationally and the introduction of 14-day mandatory quarantines in hotel prisons wasn’t conducive toward the economic profitability of aviation companies. However, we managed to survive this, but all of the aviation companies were saddled with the debts associated with maintaining the fixed infrastructure costs of an airline, without the corresponding revenues for a couple years.

Warren Buffett was previously known for his comments in various annual reports about how the aviation industry was a money pit, but also got attention of people before 2020 when he took significant minority stakes in a couple major American airlines (which he subsequently dumped after Covid hit). His justification was similar to that of what had happened to the railway industry – the industry had consolidated enough that the remaining survivors could extract the economic profits out of the system. This thesis is likely a good theory, other than when there is a global pandemic going on.

We come to the story of Canadian general aviation firms (not counting niche or cargo airlines), which is dominated by two players: Air Canada (TSX: AC) and Westjet (TSX: ONEX). Air Canada, by far, is the more dominant of the two airlines, and Westjet is not an investment option simply because Onex is a huge conglomerate of other corporations which muddies the “pure play” aspect of these companies.

Lynx Air was a Canadian low cost carrier that declared bankruptcy in February 2024. As soon as this was announced, I suddenly started getting interested in Air Canada and started doing some due diligence. Putting a long story short, because capital was no longer available at zero interest rates, it became incredibly expensive (more so than before) to obtain a bunch of cheap equity and debt capital, and lease a bunch of airplanes, assemble flight crews, purchase airport space, etc., and open up a low cost carrier. The increased interest rate environment made aircraft leasing and debt capital a lot more expensive than it used to be in the zero interest rate environment model. Every incremental exit of competition in the market is a boost to pricing power of incumbent providers. Although only approximately 30% of Air Canada’s revenues were domestic, the disproportionate increase in profitability the airline would have in being able to raise fares would result in a subsequent increase in profitability.

In addition, the historical financial statements of Air Canada at that time showed reasonable amounts of cash flow collections, and the mountain of debt they incurred during the Covid shutdown was being whittled away.

So after reading the annual report, and after the first quarterly report, I decided to dip my toes into the stock and take a position. My theory was that at their rate of cash flow generation, coupled with a boost in profitability, would come an enterprise value matching something around the pre-Covid levels (noting that AC had about 280 million shares outstanding in 2019 while today they have around 370 million).

We fast forward to July 22, 2024 when the company issues a pre-second quarter press release, generally guiding metrics downward. The release stated, “The updated 2024 adjusted EBITDA guidance range is largely driven by the lower yield environment, lower-than-expected load factors for the second half of the year and competitive pressures in international markets.”

“Competitive pressures” are two words that I did not want to be reading. “Lower yield environment” is another consequence of competitive pressures.

My thesis was toast, so I bailed out of the stock quite quickly. The fact that it was a pre-release of their actual quarterly earnings report (which came out August 7, 2024) did not help either.

We fast forward a little bit and the news concerning the looming pilot strike also took the stock down further. An airline without pilots does not function very well (although the conflict in Russia-Ukraine has shown that unpiloted devices are indeed showing that piloted aircraft are about as obsolete as battleships were in World War 2!).

However, Air Canada and the pilot union settled with a massive pay increase and they announced the third quarter result and the stock was off to the races. Even more insulting was that they announced that they finally were able to deploy some capital back to shareholders and launched a massive share buyback program – from November 5, 2024 Air Canada has been repurchasing about half a million shares a day (about $12 million dollars a day) into the open market and needless to say that puts a lot of bidding pressure on the price!

I totally missed the boat on that one. At the end, I suspect that the second quarter pre-release was a ploy for negotiation purposes with the pilot union. Had I stuck on, this particular position would have been a +50% gainer. Yuck.

The “revenge trade” is looking at something else in the sector and the only entity that warranted my examination was another competitive airline, Air Transat – (TSX: TRZ). Unfortunately for them, they look financially wrecked. Before Covid, they had a modest amount of debt in relation to their operational cash flows, but after Covid-19 they were forced to take on too much debt and this is what is going to sink them.

It is difficult to come up with a ‘normalized’ earnings or free cash flow rate for the company because its historical performance has been quite spotty, but suffice to say the sheer quantity and expensive of their debt portfolio is going to be too much for them to overcome. My rule of thumb is to exercise exceptional caution when companies have material amounts of their debt priced at a coupon higher than 10%, and indeed in this case having $670 million of your own debt at around 14% is very difficult to recover in a price-competitive industry with relatively low margins. This is a fancy way of saying that although TRZ stock is trading at all-time lows, I can’t see how they recover from this without a recapitalization.

I also note that American Airlines (AAL, UAL, etc.) have all had insane recoveries – I think the Buffett thesis on this industry has some merit and although there will be more competition with airlines than in railroads, the consolidation will likely result in some sort of equilibrium where the big incumbent players will consistently be profitable.

Finally a footnote – although I have made significant mistakes this year, there have been a few prominent publicly traded entities that have blown up that I have managed to simply not be in at the “right” time. I have written before about Slate Office REIT’s debentures, where I managed to exit in the 90’s (currently trading in the 40’s) after coming to the conclusion that a minority holder cannot win; and there have been a couple others which I have eyeballed but explicitly have not taken positions in, and only to see them tank. During this USA Thanksgiving weekend, it is something I can be thankful for. Although I am underperforming the S&P 500 (I seem to be the only person on the planet not owning NVDA, TSLA or MSTR stock!), the differential is not too wide. However, if I did not make mistakes like I did with Air Canada, I could be outperforming the index despite the portfolio being de-risked with a significant cash holding!

Strange times ahead!

(This was published about 6:50am PST on the day of the 2024 Presidential Election)

I have been on radio silence for the past month and a half for multiple reasons. I haven’t had much time for market introspection, but in light of today’s upcoming event that only occurs every four years, I might as well bat out some ill-informed thoughts. Just be cautioned that my investment radar in 2024 has been extremely poor (some of my disposition decisions have been outright terrible – when I look at stock quotes, it is like needles into my eyeballs), although I do have some good company with people with deeper pockets (looking somewhat enviously at Warren Buffet’s US$325 billion stack of US treasuries at Berkshire Hathaway, who’s probably equivalently pissed off of decreasing short-term interest rates).

The Covid-19 era of investing (specifically from February 2020 to sometime in 2022) was a very unique time in investing in that the playbook was being re-written in real time and we saw things that were never seen before in modern history – including the closure of global borders, economic shutdowns, broad-based stimulus of funds, negative spot oil prices, SPACs, etc. Those that were able to quickly recognize that the world was not going to end and that the world’s governments would be pumping an insane amount of liquidity into the financial marketplace were well positioned for what happened.

We are still living in the aftermath where the financial reverberations of the nuclear detonation are still being processed – albeit there is plenty of radioactive fallout that we see, how this translates into actionable decisions is another matter entirely. Politically speaking, the obvious erosion in our standard of living leads to anti-incumbent headwinds for those already in office, while the incumbents are busy engaging in gaslighting operations to tell the people how great everything is.

Shakespeare’s Macbeth has the famous line at the opening scene of “Fair is foul, foul is fair“, or perhaps the somewhat more modern phase from Orwell’s 1984 of “Freedom is slavery, War is Peace” is apt for this.

The entire financial world has been given about five months of notice that central banks will be decreasing interest rates and this gets baked into market pricing so when the rate drops actually occur, there is no reaction as the changes are anticipated. Instead, what has mystified casual observers is when the central banks started to do 0.5% decreases, the longer duration bond yields have increased.

We have been in an inverted yield curve environment for a very long time – the short end of the curve has been a good 200bps or so above the 10-year bond rate and this has now moderated to about 75bps (and will converge even further with continued short term interest rate cuts). The interest rate environment will be conducive to more “borrow at the short end of the curve and invest and harvest the spread” type investing, we also see the monetary base is continuing to expand once again:

Those entities that have the credit to be able to borrow at the floating rate and leverage it into a higher return on equity will do well. We have already seen this with REITs and other “yieldy” entities being bidded up significantly since the central banks started to signal they are decreasing interest rates.

However, the question continues to remain whether demand will follow as a result of credit availability. Borrowed money will not do very good if it cannot be recycled into activity that generates a profitable return – we are seeing pretty much every single G20 government blowing deficits and without this low-yield government spending, economies grind to a halt and political headwinds get even stronger.

This leads us to the presidential election.

Almost all “news” generated on this matter is utter propaganda. The signal-to-noise ratio is even worse in 2024 than it has been in 2020 or 2016. In fact, much of what is out there is like the equivalent of inferring information from static television. You then have automated engines converting this static into signal and then all the AI Bots out there turn it into purported real information, which is precisely the inverse of how a proper foundation of knowledge should accumulate. This deluge of non-information is spread for both sides of the partisan isles – the game is to silo people into their camps and incite as much emotional carnage on the minds of voters, just to eclipse the threshold that gets them to vote for the selection that they are told to support.

So I don’t pretend to know anything, but can only theorize the most rudimentary framework without looking at any polling, any “news”, or anything in particular. Reading the so-called “news” is damaging in this respect, just as it is when making most investment decisions.

My prediction is that Donald Trump will be elected as the 47th President of the USA. So instead of Grover Cleveland as being the only president serving non-consecutive terms, Trump will be the very rare exception to the history book. In fact, the political circumstances behind Grover Cleveland running three times for president and winning the first and third one has some interesting parallels to the current era, which I will leave as an exercise to the reader.

However, the 2024 presidential electoral result will not be universally acknowledged by the end of November 5, 2024. Indeed, there will be a good chance that it will take until December for this pronouncement to occur – especially the certification of specific state delegations to the electoral college.

There are a few reasons for my overall prediction, but the thesis boils down to some differential analysis of which devil the public is motivated to choose from. Your typical Trump voter from 2020 is still likely to choose him in 2024, but your typical Biden/Democratic voter will have found many more reasons to not support their horse primarily due to eroding economic circumstances – especially “non-elite” populations in urban cores of cities. While urban areas will still vote overwhelmingly democratic, the fraction of people motivated to turn out will shift subtly enough to make a difference in the states that matter. Finally, it is universally regarded that Kamala Harris is a worse candidate than Joe Biden (the Joe Biden of 2020, not the nearly comatose Joe Biden of 2024!) or Hillary Clinton. By virtue of Trump having run in 2016, 2020 and 2024 along with broadly consistent messaging, it creates a relatively easy “control” to compare elections with.

Please note that my political predictions do not constitute endorsements or condemnations of any candidates or parties. I am simply trying to gaze into my (foggy) crystal ball and predict an outcome. There is one easy prediction I will make, however – deficit spending. Cowardly politicians coupled with a public that makes little connection between government spending and the standard of living will continue to result in a steady erosion.

What does this mean for the markets? Less than people imagine – the low-interest rate environment playbook will continue to prevail, but the actual purchasing power of cash will continue to decline. Eventually we will get some sort of situation that will precipitate the reinstatement of quantitative easing – getting your standard 15% return on equity is going to get very difficult in these environments where asset prices will continue to skyrocket along with overall debt levels.

Finally, recall when Donald Trump was winning in the 2016 election, that on the day of the election S&P futures initially traded down about 4% until it came to the realization that Trump was all for a boosted stock market. There will likely be an inverse version of this happening in 2024 – while he is perceived to be positive to the stock market, I believe any such euphoria will be short-lived. The transition period between the election and the inauguration is likely to be very volatile.

What a difference interest rates make

The market has long since baked in the upcoming drop in interest rates.

As a result, anything “yield-y” have been bidded up substantially.

I note the REIT sector, which at one point earlier this year was mostly negative year-to-date is now, with a couple exceptions, up solidly.

We have the go-private transaction (99% sure to succeed) for Melcor (TSX: MRD) repurchasing the minority interest in its REIT (TSX: MR.UN) – the fact that MR suspended dividends some time ago should have given a clue as to its financial condition, but apparently they have some assets on the balance sheet that’s worth paying a healthy 60% premium to market for.

The larger REITs, e.g. REI.un, AP.un, CAR.un, etc. are all up roughly 25% over the past three months.

This is purely due to the quantitative effects of interest rates dropping. I will question the economic fundamentals of such price moves.

We also look at other (restaurant royalty) income trusts, including KEG.un, AW.un, BPF.un, etc., and they are all up. I will also question the economic fundamentals of such price moves. Do lower interest rates cause more people to go to restaurants?

While high prices are great if you are already holding and intend on selling, returns on investment drop with higher prices.

It’s getting pretty tough out there. As cash yields less and less, investors will be compelled to march up the risk spectrum to make the same returns that investors are fighting for.

The good news, however, is that having a slate that is cleaner than it has been since 2008 gives some mental clarity. I am not going to force cash to work for the purposes of increasing yield. It does hurt in some manner, knowing that every day cash erodes in purchasing power.

Despite government-published CPI statistics showing that inflation has moderated, anybody with a functioning eyeball will know that cost escalation is still significant and ongoing, especially with goods and services that people actually require. Costco is an excellent barometer for this.

The deflation you see are for goods that nobody needs. Take a look at Craigslist ads for furniture and you can explore a market that is besieged by deflation. Do you want somebody’s discarded Roomba? That can be had for $50 or $60.

There is also another metric to determine how much purchasing power has declined and that is to measure the portfolio value not in dollars but rather ounces of gold – gold as measured in Canadian currency is up almost 25% year to date, which is more than my own year-to-date performance this year. Just in case if I wanted to pull off a “Scrooge McDuck” and cash everything into one ounce gold coins and go swimming in the vault, I’d have less today than I would have last year!

Interesting times always lie ahead. The environment today is a lot more difficult than it was in 2020-2022.

Income trustworthy investments

With the US Federal Reserve imminently seeking to drop interest rates, and the Bank of Canada dropping rates a quarter point a meeting, earnings on cash are starting to decline, and all of the below will head down proportionately to the central bank rate:

(All of this assuming you can buy it at NAV)
CAD-denominated:
IBKR = 3.575% net [interest, minus CAD$13k]
HSAV.to = 3.93% net [cash, capital gains]
CASH.to = 4.02% net [cash, interest]
ZST.to = 4.34% net [6 month maturity A-AAA bond income, mixed interest, capital gains]

USD-denominated:
IBKR = 4.83% net [interest, minus US$10k]
HSUVu.to = 5.02% net [cash, capital gains]

In the Canadian market, the futures are aligned for a 25bps drop on October 23, December 11 and January 29, which will bring cash down from 5%+ to just above 3%. That will be roughly a 40% drop in income on cash in about three and half months’ time.

Needless to say all of this central bank action will be getting participants to examine the “efficient frontier” in terms of adjusting their risk-reward profiles. Instead of getting a slick 5% on risk-free cash, we will now have to explore upwards to short-term bonds, and less credit-worthy financial instruments to achieve the same amount of returns.

Unfortunately the financial markets, by virtue of future contracts, already anticipates these interest rate changes and hence anything that can provide as a substitute has already been bidded up. For example, the GoC 5 year yield from July 1st to today has gone from 3.6% to 2.8% (people will pay a premium for five years of guaranteed yield vs. a higher short-term cash yield). The Canadian preferred share market has been bidded up across the spectrum – for example, we will choose a generic preferred share, PPL.PR.O, which is trading at a 6.9% current yield and a 6.4% yield at the current GoC 5yr rate reset (essentially the risk premium is you will get an extra 3% or so for taking some duration and credit risk).

Bond-like equities also exist. Rogers Sugar (TSX: RSI) has always been one of my favourite barometers of a very stable and government-protected market in domestic sugar and their equity yields 6.4% and they pay out nearly everything in the form of dividends.

Royalties are another stable category of income. For example, Keg Royalties (TSX: KEG.un) which is a very simple income trust that takes 4% of the top-line revenues of all Keg restaurants in Canada, gives out a 7.7% distribution yield at their current payout. If you had invested in early July, this would have been a 8.7% distribution yield.

If one were to achieve a 15% return, there is nothing invest-able mentioned in this post that you can do other than to leverage up – for instance, borrow at 5% to obtain a 6.4%, 6.9% or 7.7% return – either way it is a pretty thin margin.

Needless to say, returns on risk right now are awful. Returns above the numbers presented in this post will be coming from speculative capital appreciation which makes the current environment feel more like gambling at a casino than actually investing.

There are other targets of opportunity which I have not mentioned in this post which have a little more potential, but I am still patiently waiting for a little more market stress to occur and hopefully there might be a margin call wipeout or something, just like when the Nikkei cratered 13% in one day – an event that seems to be a distant memory now.

Investing in garbage – Dollar General

It has almost been a month since I have posted, but I have been quietly stalking targets of opportunity but still remain very defensively positioned. The economic landscape out there has deteriorated somewhat and central banks are trying to get ahead of the curve by cutting interest rates. Everybody has been pointing out that this is usually indicative of bad things happening and as a result, there has been a grab for yield, especially when you look at the Canadian preferred share market.

However, something quite interesting flashed on my radar – something that I would have never anticipated taking a position in a year ago, but have just done so.

I have (post-crash from their last quarterly report) taken a modest position in Dollar General (NYSE: DG), the largest dollar store chain in the USA. With the onset of inflation, “Dollar Store” is a misnomer now, but if you want a close comparison, just walk into a Canadian Dollarama and you will have the same feel (although I must say the American dollar stores tend to have better selection and value than the Canadian version!).

The chart is an absolute train wreck:

You have to go back to late 2017 since the stock traded this low.

I’ve done the core of my research on this just over a year ago when it started to fall from market grace from US$250 in November 2022 and I closely examined it at September 2023 but decided to take a pass. The last quarterly report had me dusting off the cobwebs from my notes and memories and re-reviewing the situation and I think it is more favourable today than it was back then.

To summarize the thesis of this investment, it is a simple regression to the mean thesis, coupled with some economic protection by virtue of the sector that the lower half of the economic cohort flock toward (in other words, economic misery should benefit this company as a consumer staple provider). As investors of Dollarama (TSX: DOL) know, the store features “Amazon protection” but also a degree of Walmart protection. Temu is probably the largest competitor in this respect. The market segment is stable and there is a consider amount of incumbency protection with amortization of fixed supply chain costs.

The stock has gotten nailed on not meeting expectations – primarily that net margins have fallen off a cliff. While gross margins have remained relatively steady, SG&A expenses have ballooned considerably and this has resulted in reduced profitability.

This suggests that there is a management problem. That said, most of the upper executive suite are only in their capacities from 2023 – notably the CEO was the CEO from June 2015 to November 2022 and only took the reigns again on October 2023. Corporations of this size and scale will take some more time to regress to proper metrics. The issues should have been acutely obvious, but being able to make adjustments financially will take time – historical contracts that get signed (e.g. crappy lease locations, supply agreements, etc.) will need to run off before being renegotiated on more favourable terms.

I also note that in the 2021, 2022 and 2023 fiscal years (note: ending January of the year), they blew nearly $8 billion in share buybacks – buying back stock at their all-time highs and at levels wayyyyyyyyyy higher than what they are trading at today.

Wage and cost inflation is also an issue, but this competitive matter will affect other industry participants and will get baked into selling prices.

Other than the large amount of lease liabilities outstanding (which is natural for a retail business), the company has about $7 billion in debt outstanding which, given their cash flows and presumed stability of their business, is not excessive:

One would have wondered how stronger the balance sheet would have been had they not engaged in value-destroying buybacks, but I digress!

I do note that the July 2028 and April 2030 tenor of debt trades at 4.9% and 5.0% yield to maturity, respectively – they should have no problem refinancing current maturities at acceptable coupons. There is also a $2 billion revolving facility that remains untapped.

I expect, after some fireworks, that the company in a few years should be able to post EPS well north of $10/share. Choose your P/E multiple to slap onto the stock price and it seems like a reasonable risk-reward.

Finally, I will make one last comparison. DG had about $40 billion in sales in the last 4 reported quarters. With a market cap of $18.5 billion, this gives it a P/S of less than a half. We look at Dollarama and they have CAD$6 billion in sales and a market cap of CAD$37 billion, for a P/S of over 6! You would think Dollarama is selling AI chips or something, but instead the only chips they are selling are Pringles and Lays! Buying some long-dated puts on DOL (and indeed, the implied volatility on them is rather cheap) is something I’ve been toying with – if they break it is going to be as hard as Dollar General and you’ll see at least a 50% correction in the stock price.